2023-11-20 06:39:14 ET
Summary
- BHP is transforming its business by investing in copper and potash while gradually divesting from coal.
- The value of the coal portfolio is estimated at US$10Bn.
- Due to ongoing litigation related to the Samarco dam disaster, the majority of proceeds from a coal divestment will be diverted to a settlement.
- As the current transformation requires increased capital expenditures against a backdrop of a market in which commodity prices face a downside, it may be expected the dividend will reduce further.
- The dividend yield is acceptable, and the strategy seems solid. Yet, the high capex requirements, downside of commodity prices, and limited effect of a potential coal divestment make this stock a Hold.
Management of BHP (BHP)(BHPLF) is transforming the company through investments in copper and potash while gradually divesting from coal. The investments were described previously whereas this article focuses on the potential of divesting the coal business.
As the current transformation requires increased capital expenditures against the backdrop of a market in which commodity prices face a downside, it may be expected the dividend will reduce further to 4.6% for FY24. The uncertainties surrounding this stock combined with the acceptable yet modest dividend make this stock a Hold.
Performance
Mid-October BHP shared what it calls the 'operational review for the quarter ended 30 September 2023'. The company confirmed the production and unit costs guidance for all assets. In other words, the company is performing well in relation to the performance metrics management controls. However, the average realized prices dropped in 1Q24 compared to 2H23, see Figure 1.
Figure 1 - Realized prices, operational review 1Q24 (bhp.com)
In relation to the figure, it must be noted BHP's fiscal year runs from the 1st of July till the 30th of June. Hence, on the 30th of June fiscal year 2023 was concluded. For this reason, the company refers to 1Q24 in relation to the quarter that ended 30 September.
The reduction in realized prices is a continuation of a trend that was already visible in FY23. Figure 2 shows the FY23 earnings waterfall. From this figure, it is clear that pricing affected EBITDA by a value of US$9.3Bn.
Figure 2 - FY23 earnings waterfall, FY23 results presentation (bhp.com)
As iron ore does the heavy lifting for BHP, the commodity accounted for more than US$16Bn of EBITDA on a total of US$28Bn, it is ore prices that govern performance. Without a doubt, commodity prices have shown large movements over the last years thereby supporting the exceptional results booked in FY22. Although ore prices have come down, the commodity is still trading at an elevated level when referenced against the price development over the last decade, see Figure 3.
On the back of high commodity prices shareholders have been rewarded lavishly over the last two years, yet this is starting to show on the balance sheet. While the company kept its capital expenditures level, net debt increased to a value of US$11Bn, again see Figure 3. Although this value lies in the US$5 - 15Bn range management aims for, capex will increase to US$10Bn in FY24 and it is anything but sure the current price level of iron ore can be maintained . A combination of both factors may increase debt to the upper bound of the range.
Figure 3 - Ore price versus BHP metrics (seekingalpha.com, bhp.com; chart by author)
The increase in capex and net debt is not worrisome per se, but it does signal shareholder returns cannot remain at the current level. This is even more important to note as the FY23 presentation stated the US$11.2Bn included a sum of US$7Bn related to the acquisition of OZ Minerals. This statement however requires some nuance.
The aforementioned price is made up of US$5.9Bn in acquisition costs and an assumed US$1.1Bn in interest-bearing liabilities. Only the latter amount has contributed to the increase in net debt whereas the acquisition costs seem to be pushed towards fiscal year 2024, see figure 4. The actual driver of net debt is clearly the dividend which was more than double free cash flow.
Figure 4 - Net debt development, FY23 results presentation (bhp.com)
The presented number of US$13.3Bn does not align with the current dividend of US$1.70 per share. This has to do with the fact the dividend per share is calculated based on a calendar year whereas the recording on the balance sheet is done according to the fiscal year. As this may lead to confusion, it's easier to look at the number of shares and the dividend per share. With a weighted average of 5 billion shares outstanding, the annual cash outflow due to dividends is US$8.5Bn.
As the current indebtedness and ore price level align with the 2020 numbers, as visualized in Figure 3, my expectation is the dividend will be reduced further to a level of about US$7Bn, or US$1.40 per share. With a 2:1 ADR ratio, the forward yield becomes 4.6%.
Diversification and divestment
In my previous coverage of BHP, it was argued the company is in the midst of a transformation . The article highlighted the effort put into the development of the Jansen potash mine, but also clearly showed the majority of capex is directed at copper. Both commodities are future-proof and hence the rationale for investing in both is sound.
What the article did not cover was the existing coal business of BHP. Although a highly lucrative business, evolving societal beliefs will make this business a liability over time. In June this year, a presentation on decarbonisation was given by the company. Interestingly only the scope 1 and 2 emissions were highlighted whereas the real liability is with the scope 3 emissions.
Generally speaking, scope 3 emissions are those resulting from products the company sells. With coal being labelled one of the worst fossil fuels concerning carbon dioxide emissions, the potential liability will have the attention of management, especially after the landmark ruling against Shell in 2021. In the ruling Shell was held responsible for all emissions, scope 1 to 3.
In brief, it is my belief that diversification into potash is the prelude to an exit from the coal business.
Valuation of coal business
The idea for a coal divestment is not extraordinary as BHP has divested a substantial part of this business already over the last two years. Working under the assumption management shares the intention to divest the entire coal business, it becomes worthwhile to determine a ballpark figure for the valuation.
Teck deal
The most recent transaction of a sizeable coal mine happened on the 14th of November when Glencore (GLCNF)(GLNCY) confirmed the acquisition of a stake in the coal business of Teck Resources (TECK). While it was already known Teck intended to spin-off the coal unit, the latest news actually puts a number on the valuation, see figure 5.
Figure 5 - Transaction value of Teck Resources' steelmaking business, Teck Conference Call presentation (teck.com)
The US$8.9Bn does not say much on its own, other than it being a big number. Fortunately, management at Teck has put the valuation in perspective, see Figure 6.
Figure 6 - Teck transaction valuation of coal business, Teck conference call presentation (teck.com)
In terms of EV/EBITDA ratio, the deal seems worthwhile for Teck. The problem with this metric however is that coal prices have fluctuated a lot over the last years implying earnings may be unsustainable. For example, in 2022 Teck's realized coal price increased by 70% to 355 US$/t (2021: 209 US$/t).
Another way to assess the valuation of Teck's coal business is to look at the reserves. According to the latest annual report, the total proven and probable reserves of coal were 806Mt. At a price tag of US$8.9Bn, this translates into a value of 11 US$/t of coal reserve.
BMC and BMA divestments
Last year, BHP divested its 80 percent interest in BHP Mitsui Coal [BMC]. Stanmore SMC (STMRF), the party buying the assets, agreed to pay US$1.35Bn. The two locations under consideration in this deal were South Walker Creek and Poitrel. According to the 2022 annual report of BHP, these two locations combined accounted for 137Mt of Total Marketable Reserves. As the interest of BHP in BMC was 80%, the reserves attributable to the company were approximately 110Mt. Applying the same rationale as for Teck, the BMC divestment commends a valuation of 12.27 US$/t.
In a similar fashion, this year's divestment of the Blackwater and Daunia mines can be valued. Both mines were part of the BHP Mitsubishi Alliance [BMA]. BHP agreed to sell these locations to Whitehaven Coal (WHITF) for a cash consideration of up to US$4.1Bn. According to the press release the BMA mines contain combined Marketable Reserves of 183Mt. This implies the transaction is valued at 16US$/t of coal reserve.
The number
According to the latest annual report of BHP, the coal portfolio still contains 1424Mt of marketable reserves, see Figure 7. As the BHP interest in the mines is 50% for the entire portfolio, the reserves attributable to the company are half as well, or 712Mt.
Figure 7 - BHP Total Marketable Reserves, AR23 (bhp.com)
While this total number is less than the reserves of Teck, BHP has demonstrated the ability to sell its coal assets at a premium when the marketable reserves are taken as a starting point. Teck's coal business was valued at 11 US$/t whereas BHP has offloaded some Australian assets for an average price of US$14/t. Based on this number, BHP's remaining coal portfolio is valued at US$10Bn.
Sword of Damocles
In addition to the coal business potentially turning into a liability, BHP is still involved in litigation concerning the Samarco dam disaster. The most recent development in this case is the willingness of BHP to settle . Brazilian prosecutors demand approximately US$32Bn in compensation from Samarco. As Samarco is a 50/50 joint venture between Vale (VALE) and BHP, it may be assumed ultimately half the settlement will have to be shouldered by BHP, implying a potential liability of US$16Bn.
In case of a settlement it's not likely the full amount will be paid. Nevertheless, given the devastation the disaster caused, prosecutors will not settle for a small number either. Putting a number to a potential settlement would be a guess, but my base case is it will be several billions. As such, the majority of proceeds from a potential coal divestment would be diverted towards the settlement with the remainder likely used to reduce net debt.
Conclusion
BHP is continuing its transformation which will take several years to complete. The investments in copper and potash were described previously whereas this article focused on the potential of divesting the coal business.
Such a divestment would mainly be done to avoid future litigation now changing societal beliefs will make this business a liability over time. As the Samarco litigation is hanging like the sword of Damocles over the company, it is assumed the majority of proceeds from a potential coal divestment will be diverted to a settlement. This implies shareholders will see little additional returns other than a reflection of reduced uncertainty in the share price.
As the current transformation requires increased capital expenditures against a backdrop of a market in which commodity prices face a downside, it may be expected the dividend will reduce further. For reference, the 2020 dividend outflows of US$7Bn have been used to arrive at an estimated forward dividend yield of 4.6%.
Being a long-term investor the dividend yield is acceptable and the strategy seems solid. Yet, the higher capex requirement, the downside of commodity prices, and the limited effect of a potential coal divestment make this stock a Hold for me.
For further details see:
BHP: Coal Divestments To Continue (Rating Downgrade)